The value premium in a nutshell

Loading up on the value premium is the financial equivalent of exploiting the sick and the weak. You’re putting the returns of vulnerable companies to work in your portfolio.

Why? Because in the past they’ve proved capable of delivering better results than glamorous growth stocks such as Facebook or Apple.

This extra return available to investors is known as the value premium and it’s one of a suite of return premiums that can power up your portfolio.

But it’s completely counter-intuitive. How can a spluttering firm possibly hope to outshine a trailblazing company whose brilliant ideas are catching fire across the globe?

Well, it’s important to understand we’re not talking about pitting some ailing local newspaper group in a mano-a-manopit fight with Google.

What we are saying is that the relative average performance of ‘value’ companies has been better than ‘growth’ companies, as a group and over long periods of time.

Why should that be?

There are two main explanations as to why value companies outperform.

One is that investors tend to overpay for growth companies. They get overexcited about the possibility of discovering the next Google and so shell out too high a price for the golden ticket.

Many growth companies don’t live up to their billing and, as a group, they can’t generate the returns that justify their high valuations. In comparison, value companies are underrated. They thus have the potential to bounce back.

The other explanation is that investors wrinkle up their noses at the stench of decay lingering around value companies. They know value companies are risky. Rightly enough, they want to be compensated for taking on that risk with the prospect of a higher expected return.

Value companies have to go cheap in order to entice investors. Think of the bargain shelf in the supermarket full of battered and bruised products at knockdown prices.

How do I spot a value company?

A value company generally has a low market price in comparison to a series of stats that measure its financial health. These stats are often described as a company’s fundamentals.

Lower ratios can indicate that a company is undervalued and so could turn up trumps if its situation improves.

Equally, the subdued prices warn that the company is wobbly.

Value companies are often characterised by high debt levels, volatile earnings, and volatile dividends. They are particularly likely to be punished in times of recession, when they lack the agility to respond to worsening conditions because they:

Struggle to innovate.

Can’t easily ditch surplus capacity when demand goes south.

Are highly leveraged so aren’t exactly favourite for new loans to bail them out.

Risk story

All this is why there’s very real risk attached to investing in value companies.

Although you can diversify away individual company risk by investing in a fund or ETF, value companies as a whole can get pummeled for protracted periods.

In the US, the value premium was negative for 12 years between May 1988 and October 2000.

Its annual volatility has been around 14% per year (in the US) so a value investor has to be able to live with trailing the market.

On the upside, the value premium has averaged 4.9% per year between 1927 and 2010 in the US.

The premium was 3.6% in the UK between 1956 and 2008.

These numbers explain why some investors, including me, are persuaded by the research to devote at least some – perhaps 10% – of their equity allocation to passive funds that follow a value strategy.

But beware, the value premium has been negative for four of the last five years between 2007 and 2012 (in the US).

There’s no guarantee that the premium will perform well – or even persist – into the future. That’s the risk for which we hope to be rewarded.

Take it steady,

The Accumulator

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Hi TA, nice (funny) summary – I like the “stench of decay” line! But… I would add a slight refinement and split value investing into two broad camps.

You’ve more or less described “deep” value investing; the search for bargain ‘cigar butts’, which is a style with a long and successful history.

But there is also quality value investing, which is what Buffett, Woodford, Terry Smith and others (i.e. me) practice, where the “stench of decay” is often mild and usually non-existent.

Regarding value tilt, if an investor is going to bother going beyond 50/5o or 60/40 stocks/bonds, then they might want to look at Dimensional Fund Managers documents, as they have tons of useful info… a summary of which is at:

Apple not a value stock?
That’s what I had it down as but maybe not,at $432 (the price I paid) it looks very close to value,140 billion cash P.E of less than 7 if you strip cash out.P/b P/cf p/s not bad.
It’s not as racy as it was but it’s taken a big beating and is definatly out of favour.

@Steve — I think the whole ‘sturm und drang’ about Apple is about whether it’s now an ex-growth stock, or even value as you say, or whether it’s a growth stock that’s just down on its luck. 🙂 I tend to think like you (and hold it accordingly).

@ rjack – 80% would seem less like a tilt than a headlong dive into the value camp. And I don’t have any issue with that as my guess is you’re well aware of the potential risks and rewards. 10% isn’t a recommendation, it’s just indicative of what a tilt might look like. I based it on model portfolios offered by commentators such as Tim Hale: http://monevator.com/9-lazy-portfolios-for-uk-passive-investors-2010/
Of course, you can tilt more heavily in favour of value or any other return premium, if you’re convinced by the arguments and your ability to stay the course when the style lags the market. Something like William Bernstein’s Four Corner’s Portfolio weights 30% to value and the same again to small cap.

@ John – Glad you liked the article. I was just characterising the explanations for the existence of the value premium. If you subscribe to the idea of value as a risk story then a ‘quality’ value company is presumably seen as riskier because it’s no longer obvious that it can maintain its position. Apple is a world-class company, but if Steve is right, and Apple is now thought of as a value stock, then one explanation is the risk that Apple is being overhauled by its rivals in a brutally competitive sector.

Totally agree. The high PE of growth stocks HAS to come down to earth at some point. There hasn’t ever been a stock with a PE over 30 sustained for more than 50 years. But there have been plenty with PEs of 10 or less which have.

In the long run, the super-long run, there is only one metric that counts, and that’s earnings (and its growth). Over time every other metric comes and goes in significance, but only the “real deal,” the earnings, defines the performance of a company. It’s the E in PE, and no matter how low the PE is, growth in E leads to growth in the price.